Archive for the ‘Investor Education’ Category

Closing in for the kill in value investing

Monday, January 3rd, 2011

In our previous two articles, Choosing the businesses with strong economics- Part 1: avoiding poor economics businesses and Choosing the businesses with strong economics- Part 2: finding durable competitive advantaged businesses, you have learnt about which businesses to avoid and which ones to look out for as your investment candidates. Once you have identified such businesses, the next question is, when do you make a move to invest in them?

First, you need to have some idea how much that business is worth. Our previous articles, Measuring the value of an investment and Effects of inflation on value of investment will give the mathematical explanations on how to value a business. But do not confuse mathematical precision with accuracy. As we said before in Confusion between precision & accuracy,

As the above-mentioned analogy shows, precisely wrong numbers are useless. If we use them, then the quality of our investing decision will degrade considerably.

For this reason, it is better to be vaguely right than to be precisely wrong.

Second, you must remember this: never ever pay for more than what the business is worth. In fact, it is advisable that the price you pay be of a certain margin (say 15%) below its worth. This is to give you a margin of safety against errors in judgement.

The next step is to wait patiently, stalking the business like a hunter. Eventually, bad news will strike the business, revealing the changes that will occur. Then the stock market will typically overreact, pulling the stock price to a level that is far below what it is worth. That will be the time to strike. The stock market overreacts because it is not rational and suffers the common mental pitfalls that ail every human. To be a successful investor, you need to be more rational than the market collectively. We recommend that you familiarise yourself with the common mental pitfalls as explained in our guide, Common mental pitfalls that leads you astray and Why are the majority so wrong at the same time and in the same ways?.

However, this step is the trickiest one and errors in judgement are most likely to be made. Bad news comes in two flavours:

  1. Changes to the business are temporary and therefore, a recovery will eventuate in due time.
  2. Changes to the business are permanent and therefore, there will be no recovery.

Thus, you have to discern the nature of the changes, understanding whether the context of the underlying trends in which the business changes occur is secular or cyclical (see Understanding secular vs cyclical). For example, as we explained before in Should value investors be ?bullish? in a bear market?,

One value-oriented stock research (which we will not name) believes that this current bear market will be like any other ?typical? bear market in the past- the downturn will last only 12 to 18 months. In other words, their position is that this coming recession will only be a V-shape or U-shape recession (see What type of recession is coming?). If they are wrong about that (i.e. the coming recession is an L-shape one), then their current ?Buy? recommendation will be very wrong.

In short, not all bear market purchase will turn out to be astute if the timing is way too early.

This is where value investors are most likely to get wrong.

Epistemic arrogance, running through traffic lights & Black Swans

Thursday, November 25th, 2010

Today, we received an email from one of our readers. After reading Failure to understand Black Swan leads to fallacious thinking, this is what he thought:

I liked your use of the term “Epistemic arrogance”. Recently I was driving and almost ran straight through a red light at a pedestrian crossing and I was trying to think how I could have been so reckless. I mean I am a great driver (?) and I had been down that road numerous times, yet I still almost managed to run down an almost-unfortunate couple. Sure the red light is in a seemingly random position, and the green light at the intersection 50m down the road can cause very slight confusion, but a red light is a red light.

Its then I theorised the issue. If it was my first time driving, or my first time driving down this road, there would be no way that I would have missed this red light. I would watch out for all hazards because I know that I don’t know. An arrogant driver on the other hand, as I was, thinking they know the lay of the land, can get into strife when the unexpected (in their mind) pops up.

Its this “epistemic arrogance” which leads the learned to cause crashes and accidents… I’m sure there are many top minds in the world who fail to look beyond their view… Learning from one’s mistakes is a great way to improve your management of risk!

This is a very great point. And by the way, it is Nassim Nicholas Taleb that came up with the term “”epistemic arrogance.”

We also have an example that is relevant to investing. Marc Faber once mentioned that the financial valuation of asset prices severely underestimate the possibility of geo-political Black Swans. The recent North Korean artillery pot-shots at their southern neighbour is a case in point. The US and South Koreans are planning to hold military exercises this coming Sunday in response to North Korea’s provocation. The North Korean had already warned repeatedly that they will be provoked with such actions, especially when they are happening so closely to the border. With a juvenile rookie dictator-in-waiting probably calling the shots in Pyongyang, we wonder at the wisdom of the American and South Koreans.

The Korean peninsular is just one example of geo-political Black Swans. We can also include Afghanistan, Lebanon, Iran, Pakistan as well.

Another biased media report: home loans on the rise?

Tuesday, July 13th, 2010

In our report, How To Foolproof Yourself Against Salesmen & Media Bias, we wrote about how the media uses headlines to slip in their bias.

Well, here is a great example from this article in the Sydney Morning Herald (SMH)- Home loans on the rise:

The number of home loans issued to borrowers have marked their first rise in eight months are buyers looked beyond higher interest rates to wade back into the market. In a sign of caution, though, the size of a typical loan shrank.

In an another article from the SMH- Home loans up for first time in eight months:

A WEAK spot in the property market is showing tentative signs of recovery, after a surprise bounce in new lending to home buyers.

The headlines from the Daily Telegraph isn?t much better.

Despite the positive spin in these headlines, there?s a little detail that caught our eye. What is it?

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Should precise percentage of odds (of whether something will happen) be treated as nonsense?

Tuesday, June 29th, 2010

Recently, we saw an article that reported,

There is a 10 percent to 20 percent chance of BP being taken over,? said Gudmund Halle Isfeldt, an Oslo-based analyst at DnB NOR ASA, in an e-mailed note this week.

Whenever we read about analysts stating precise odds about whether certain event will happen (e.g. takeover, interest rates movement), we get very suspicious. How do they come up with such precise percentage? More importantly, are these kinds of precise numbers valid in the first place? If not, why?

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Trend followers alert: gold breakout!

Sunday, June 20th, 2010

For those of you who are into a trading technique called “trend following” (or “momentum trading”), you will want to know that gold prices had broken out of its trading range last Friday at around US$1256. For those who are unacquainted to trading, trend following traders are always on the lookout for prices that “break out” of a trading range in search for a trend to ride on.

The tricky issue for Australian traders is that though gold prices had hit a record high in US dollar terms, it is still below the record high in Australian dollar terms (in the first quarter of 2009).

Our? friends from Market Club has more detailed explanation on the charts here.

Meanwhile, for those who are into stock-picking, it is time to compile a list of stocks that you want to buy. We will talk more about it in the coming articles.

Are you a range trader or trend follower?

Thursday, April 1st, 2010

Remember, back in Explosive gold price movement ahead. But up or down?, we showed you that gold prices had been bound within a range from February 2009 to the day when the article was written (September 2009). As we showed you in the price charts, the range got progressively narrower and narrower as the months go by. That gave rise to a price formation called the ?pennant.? As we wrote in that article,

A pennant is like a spring coiled up, ready to jump [either up or down] at any moment.

Not long after we wrote that article, gold prices broke out of the range and made a record high of US$1,226.37 on 2 December 2009. Today, gold prices are range bound again.

How to buy and invest in physical gold and silver bullionIn 2005, we remembered the headline from the Australian Financial Review (AFR) screaming “gold fever” as gold prices hit US$500 for the first time in many years. As the crowd piled into gold, driving it to a then record high of over US$730 before a major correction threw it down to a low of around US$540. Then gold was range bound for about a year before making another dash to above US$1000 before the Panic of 2008 crashed it to around the US$700 level. Then it recovered, made another dash to US$1000 before being range bound again. The rest of the story you know.

Do you see a pattern? Basically, the story goes like this: range-bound, break out, dash up, correction, range-bound… rinse and repeat. You can visually see this pattern nicely in the Why gold will not make new highs or lows this year video made by our friends in Market Club (which we have an affiliate relationship with). If this pattern repeats itself, we may see gold prices becoming range bound for the rest of this year before making a record high next year.

For those who are into trading, this is a good opportunity to engage into “range trading.” The principle behind this type of trading is very simple- sell when prices reach the upper range and buy when it reaches the lower range.

For traders who engage in “trend following,” they follow a different approach. They wait for break-outs of the range and buy/sell accordingly. For example, if gold breaks out of the trading range upwards, they buy.

Is it possible to be a range trader and a trend follower at the same time? One old trader told us “No, unless you are extremely smart.” Why? When you see gold prices reach its upper range, a range trader will sell (or short sell). A trend follower, on the other hand, will buy.

What if you are trying to be both? Do you buy or sell?

Hoodwinked by Craig James’s “CommSec National Performance Gauge”

Thursday, March 25th, 2010

Just this week, CommSec’s Chief Economist, Craig James released a CommSec National Performance Gauge that purportedly declared that Australia have never had it so good (as at end of 2009). According to this news media article, Craig James was quoted as saying,

The CommSec National Performance Gauge attempts to fill the void by focusing on issues that matter to ordinary Aussies. That is, financial decisions like buying a car or house, filling up the car with petrol, the state of the job market, wages and confidence levels.

That gauge takes seven measures, of which four of them involves spending capacity. Among the four, one of them is on car affordability. As that article reported,

The gauge shows that car affordability is the strongest in 35 years, taking a person on the average wage just under 30 weeks to buy a new Ford Falcon, down from 36 weeks five years ago.

The idea is that as the number of weeks an average worker earns to buy a car decreases, the ‘better’ and ‘more’ well-off’ this measure indicates. A car is probably chosen because it is representative of the material well-being of Australians. According to our friends at FN Arena (please note that the original article has an overall air of sarcasm against Craig James’ gauge),

But in the wider cohort, income per capita is up 6% over five years and retail spending up 7%. Today it takes 30 weeks of average wages to buy a new Falcon, down from 36 weeks five years ago and the most affordable level in 35 years. It takes 1.58 weeks of average wages to make one average mortgage payment, which despite ?unaffordability? cries is the same level of five years ago. And despite rising oil prices, drivers can afford 7% more petrol from the average wage than five years ago.

That sounds correct right?

Unfortunately, if you’re not careful, you can fall for a mental pitfall here. Even Craig James was reported to qualify his exuberance by saying, “that is probably a big call and one that would attract a lot of discussion.”

So, what is the mental pitfall trap hidden within this performance gauge that can lead you astray?

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How To Foolproof Yourself Against Salesmen & Media Bias

Sunday, March 21st, 2010

Over the weekend, we have released a new instant download, PDF report, “How To Foolproof Yourself Against Salesmen & Media Bias” at only US$4.95. In addition, we had set up a Facebook Group related to this report for those who want to discuss more on the topic.

Basically, this report is an expansion and rehash of the mental pitfall series of articles (some of which are still available in this web site) and written from a different perspective. This report is divided into two parts. The first part is the most important part- it expands from the common mental pitfalls ideas on this web site:

  1. Accuracy-Precision Confusion
  2. Anchoring
  3. Bigness Bias
  4. Confirmation Bias
  5. Correlation-Causality Fallacy
  6. Endowment Effect
  7. Herd Behaviour
  8. Lazy Induction
  9. Ludic Fallacy
  10. Mental Accounting
  11. Money Illusion
  12. Narrative Fallacy
  13. Overconfidence
  14. Recency Bias
  15. Status Quo & Loss/Regret Aversion Bias
  16. Sunk Cost Fallacy
  17. Survivorship Bias
  18. Turkey Thinking
  19. Wishful Thinking

The second part is on some of the common tricks employed by biased media:

  1. Context Twisting
  2. Headline Judgement
  3. Images
  4. Names, Titles, Word Choice & Tone
  5. Selection & Omission
  6. Source Bias
  7. Story Placement

This report is in the PDF format and the total number of pages is 50 pages. It is specially designed to look well as a slide presentation, which means the larger fonts will be easier on your eyes. That makes it an ideal e-book. You can also print this PDF report but we would urge you not to do so for the sake of the trees.

For those who had already donated to this web site, this report will be given to you free of charge. You will receive an email from us (sent via e-Junkie) with the download link.

Click here to get this report now!

Thinking tool: going beyond causes & effects with systems thinking

Wednesday, March 3rd, 2010

Recently, we were reading a property investment newsletter. As expected, it listed reasons why despite house price inflation over the decades, housing is still ‘affordable.’ One of the reasons is this: Decades ago, families lived on single income. Today, families are living on double income, which means their purchasing power had increased over the decades. Hence, with increased purchasing power, house price increases. Basically, the increase in the number of dual-income households is (one of) the cause and house price inflation is the effect.

At first glance, this cause and effect seems logical isn’t it? Is this argument the truth? We don’t know, but we know that if one buy into that argument, then that’s another justification for house price inflation, which depending in one’s bias, is good enough.

What if we reverse the cause and effects? That is, house price inflation is the cause and the increase in the number of dual-income households is the effect? Another way of saying that is that as houses become more and more unaffordable, more and more families are forced to depend on dual income to service the mortgage debt. Certainly, this is the situation of young families nowadays.

Now, the point of this article is not to argue which is the cause and which is the effect. Both of them are unprovable interpretations. Since they are unprovable, each of them panders to our beliefs and bias. The main point of this article is this: always be alert to reverse the and cause and effects and see if the logic still holds. If so, you may be on to something more subtle and complex.

In this example, the property investment newsletter’s interpretation is probably an oversimplified narrative. Human nature is such that everyone has an unbreakable habit of simplifying and reducing the complexities in life into easy to understand story. As we wrote before in Mental pitfall: Narrative Fallacy,

Narrative Fallacy is a natural human weakness because by default, our minds seek to form theories, jump into conclusion, seek judgements and explain what we see. It takes a conscious act will to do otherwise.

The reality could be more complex than just a simple cause and effect. It is possible that over the years, rising house price (among other factors) led to the effect of more dual income families (among other effects), which in turn led to even more rising house price, which in turn lead to more dual income families and so on and so forth. In other words, the cause leads to effect, which feed-back into causes, which in turn feed into more effects i.e. a positive feedback loop.

If you can think along this line, congratulations! You’re now utilising systems thinking. Systems thinking is a very important skill that can gives you the edge not only in investing, but also in other aspects of life. We will be covering more of systems thinking in the days to come. Meanwhile, if you are interested to learn more on your own, we recommend this introductory book: The Art of Systems Thinking. This is a fascinating subject and we can only bring it to life through practical examples in the field of investing and economics.

Lastly, our friend, Professor Steve Keen utilises systems thinking in his modelling, which is something that neo-classical economists are lacking.

Mental pitfall to avoid: mental accounting

Tuesday, February 23rd, 2010

Following feedback from our readers, we learnt that many are interested in learning more about the mental pitfalls that afflict every human being. To be a good investor, one has to overcome or at least be aware of his/her vulnerability to mental pitfalls in order to make rational investment decisions. If you can do that, it will, by definition, make you a contrarian investor.

Today, we will look into mental accounting. In mental accounting, individuals tend to divide up their current and future assets into separate accounts and then assign different subjective values to these accounts.

Let’s look at the following scenarios:

  1. You divide your total wealth into two accounts: Retirement Account and Speculation Account. The former is meant to be ‘safe’ place to store your wealth for future retirement while the latter is for you to gamble in the financial markets. Say, you gamble $10,000 and lost the entire lot. Which outcome will make you feel better: (1) you lost $10,000 on the Retirement Account or (2) you lost $10,000 in the Speculation Account?
  2. Say you invest in stock A and B. The price of stock A decreased by 10% whereas the price of stock B increased by 10%. Let’s say you have to raise cash in a hurry. Everything else being equal, which stock will you liquidate in order to raise cash?

In the first scenario, chances are, a person using mental accounting will feel more pain in outcome (1). In the second scenario, one is more likely to sell the winning stock. But if one looks at them rationally, there’s no different between either outcomes in both of the scenarios.

The root characteristic of mental accounting is that it violates the principle that money is fungible. Recall that in Properties of good money, we wrote that

Any commodity that functions as money ought to be fungible. That is, you can trade or substitute it for equal amounts of like commodity.

To put it simply, a dollar is a dollar, no matter where it pick it up from. A dollar you deposit in the bank is not exactly the same physical dollar when you withdraw it three days later. But for all intention and purposes, both of them can be substituted for each other.

Diamonds, on the other hand are not fungible. Each is unique from the other and hence, cannot be substituted for another. Your pet dog is not fungible too. If it died over the weekend, you cannot simply pick a similar one from the pet shop and substitute it for your dead pet.

In the same way, a dollar in the Retirement Account is fungible from a dollar in the Speculative Account. But the fact that one is more likely to feel more pain from a loss in the Retirement Account then an identical loss in the Speculative Account shows that both dollars are no longer fungible in one’s minds.

Arguably, mental accounting helps make Kevin Rudd’s free $900 stimulus cheques more effective (in ‘stimulating’ the economy) then it would have been. Tax-payers who received $900 tend to put the that in the “Free Lunch” mental account. Money in the “Free Lunch” account is more likely to get splurged on consumer items that make one feel good. What if the government made that $900 be automatically credited into tax-payers’ debt account (e.g. mortgage debt, credit card debt)? In that case, most will be reluctant to spend $900. In both cases, the government spends $900 and each tax-payer’s network increased by $900. But the latter will result in most people choosing to close up their wallets. The rational choice in the former case would be to repay debts.

In another real-life example, one of our Chinese friends made an investment in physical gold and managed fund in 2007. As we all know, both the Chinese stock market and gold fell in the second half of 2008. By early 2009, he had made some paper profits in gold while the managed fund was still in the red. Due to some personal circumstances, he had to raise funds. So, he sold his gold for a tiny profit. Today, gold is at a much higher price than when he sold it and his managed funds is still in the red. The reason why he sold his gold was not because he believed that managed funds had a better prospect. Instead, he the reason was because he did not want to realise the losses in his managed fund.